According to the China Securities Regulatory Commission (CSRC), the long awaited Shenzhen-Hong Kong Stock Connect (SZ-HKSC) program is expected to launch in mid- to late November. Approval of the new scheme follows the November 2014 initiation of the Shanghai-Hong Kong Stock Connect (SH-HKSC) and is a potentially significant step forward in China’s capital market opening to the rest of the world.
At the broadest level, the Shanghai and Shenzhen programs represent milestones in an ongoing process of harmonisation of international markets.
Of course, with harmonisation comes challenges. As a case in point, the SH-HKSC faced challenges such as reconciling operational and legal frameworks on both sides of the link, including the need to align global market practices and procedures within the world’s second-largest economy. Similar challenges surely await the Shenzhen connect, leading many to question whether the launch will proceed smoothly.
Shenzhen-Hong Kong Stock Connect Building on Lessons Learned
The Shanghai-Hong Kong Stock Connect’s operational requirements are complex and are no doubt being studied in depth ahead of the planned launch of the Shenzhen initiative.
For example, SH-HKSC originally required shares to be held in investors’ trading accounts the previous day (T-1) for them to be sold on T+0. For northbound institutional investors, this meant shares had to be transferred to their executing broker before the trading day started. As a result, sell orders had to be planned well in advance – up to two days in advance for North American investment managers – introducing market risk that would not otherwise exist. This requirement, in addition to SH-HKSC’s hybrid settlement cycle, which required trades to be settled on T+0 but did not disburse cash until T+1, introduced up to three days’ counterparty and market risk for investors outside Asia.
The April 2015 introduction of client-segregated accounts within Hong Kong Exchange and Clearing’s (HKEX) Central Clearing and Settlement System (CCASS) partially addressed the pre-delivery challenge. In principle, this allowed the exchange to pre-check shareholdings without the need for physical pre-delivery. However, risk associated with the absence of Delivery Versus Payment (DVP) still discouraged some investors – this despite HKEX’s efforts to encourage brokers to lend funds to clients waiting for trade settlements.
Operational complexities also arose from the requirement for renminbi (RMB) settlement without access to a foreign exchange facility for trades made via the Shanghai-Hong Kong scheme, adding a layer of cost and market risk that does not exist in the Hong Kong market itself.
The Shenzhen and Hong Kong exchanges and other agencies involved in launching the new link will have the luxury of being able to have taken on board lessons learned from The SH-HKSC launch. Indeed, in this context the SH-HKSC can be viewed as a pilot project for China opening its capital markets to global investment. This could smooth the roll out of the Shenzhen scheme.
Investors Should Be Prepared to Face Trading Challenges under SZ-HKSC
That being said, the Shenzhen and Shanghai markets are quite different. Shenzhen is well known for two market niches: small to medium caps and start-ups. These include many so-called “new economy” stocks in the pharmaceutical and clean-energy technology sectors. Shanghai, on the other hand, consists primarily of more mature industries, including financial stocks. Therefore, the Shenzhen program is likely to attract a different mix of trading strategies and investors when launched.
Operationally, some of challenges could be similar to those faced by the SH-HKSC scheme. However, the new stock connect program could pose specific new challenges for different types of investors and institutions.
For example, to date hedge funds have dominated buy-side activity on the Shanghai-Hong Kong connect, which gave many of them direct access to China A-shares for the first time. However, quotas and limits on day trading and short selling have nonetheless dampened participation by this key segment, which would otherwise be attracted to the Shenzhen market’s smaller and more volatile stocks. It’s possible that similar operational barriers could have an equally significant impact on hedge fund activity when the SZ-HKSC program is launched.
Robust operational processes key to dealing with complexity of dual market environment
In terms of market participants themselves, a key learning for brokers, custodians, investment managers and other players is the need to consider more scalable processes and solutions as they prepare to participate in an additional China-Hong Kong equity market link. In particular, we believe that a significant proportion of firms trading under the SH-HKSC scheme today are relying on manually intensive, ad-hoc middle- and back-office trading systems and practices in the hope of “getting by” operationally, while they reap the benefits of participating directly in China’s stock market.
These firms need to carefully consider how scalable these arrangements are, particularly as the Shenzhen-Hong Kong Stock Connect program launch will inaugurate a multiple-market stock connect program in China. Mixed asset investment managers and brokers must be prepared to deal with the potential complexity of such a market environment. Indeed, with such a significant market opportunity at stake, now is not the time to underestimate the importance of sound operations processes and technology and getting the middle and back office functions right.
Matthew Chan is head of Product & Strategy, Post-Trade Services (APAC,) at The Depository Trust & Clearing Corporation. This bylined article first appeared in The Asset.